What is natural capital and what does it mean for investors and lenders in the UK and Europe?

Natural capital is defined in the Convention on Biological Diversity (the first global agreement to cover all aspects of biological diversity which was signed by 150 government leaders at the 1992 Rio Earth Summit) as "the world’s stocks of natural assets which include geology, soil, air, water and all living things". It is relied on for a wide range of services – often referred to as ecosystem services. It includes things like food, water and plant materials used for fuel, building materials and medicines, as well as the climate regulation and natural flood defences provided by forests, the billions of tonnes of carbon stored by peatlands or the pollination of crops by insects.

The importance of minimising the impact of industry on nature is increasingly driving corporate agendas. There is also a growing understanding of the role that nature can play in environmental compliance. The Natural Capital Committee (now disbanded, but originally set up as an independent body to report to the UK government and advise on how to value nature and manage "natural wealth" efficiently and sustainably), spoke about natural capital as underpinning other types of capital and as forming "part of our wealth; that is, our ability to produce actual or potential goods and services into the future to support our wellbeing".

One other significant role natural capital plays is as a part of the offsetting market. Many carbon offset projects rely on natural capital enhancement to help mitigate carbon emissions – examples include afforestation or peatland restoration. As the trend for offsetting environmental impacts continues and markets for purchasing offsetting credits develop, it is likely that the value of natural capital and the associated ecosystem services it offers will be increasingly recognised.

Why does natural capital matter to investors and lenders?

There is a clear trend forcing businesses to consider and account for their impact on the natural world, both directly and indirectly, and to be transparent about this impact and what they are doing by way of mitigation.

Socially conscious investors have for some time now used the concept of ESG or environmental, social and corporate governance as a set of standards for a company’s operations to screen potential investments. These non-financial factors form part of the investment analysis which will look to identify material risks and growth opportunities.

Natural capital is one part of the "E" of ESG, which looks at how a company performs as a steward of nature. The criteria can also be used to evaluate environmental risks a company might face and how the company is managing those risks. Examples include the extent to which a business's operations might be affected by continued biodiversity loss, constraining its ability to source raw materials used in its products or processes. Increased regulation in this area might also force businesses to change the way they operate, for example if they rely heavily on commodities which are linked to deforestation.

For the investor and lender community there is the potential for the impact of this trend to be felt in two main ways: firstly in terms of their own business activities, for example who they choose to lend money to or the projects they opt to invest in, and secondly what they choose to do in their own right to engage with the drive to be more environmentally sustainable.

Increasing legal obligations

While many of the nature-related legal requirements are currently voluntary, the impact of a business's activities on nature is likely to come under increasing scrutiny in the coming months. A number of recent legal developments will catch a wide range of businesses in the UK and EU, including on biodiversity net gain, nature-related disclosures, new climate and nature targets, and supply chain transparency.

As of 12 February 2024, the biodiversity net gain regime or BNG is mandatory in England, meaning that any development which impacts on onsite habitat and requires planning permission will need to show a 10% increase in the biodiversity value of the site post-development against a pre-development baseline. Should a 10% increase not be achievable on-site, developers will need to offset the impact elsewhere, either on other landholdings or through purchasing biodiversity units from a third party. There are only limited exceptions to this requirement. The new regime could therefore drive up the cost of project development, as well as potentially influencing the value of real estate.

In September 2023 the Taskforce for Nature-related Financial Disclosures (or TNFD) launched its recommendations and guidance. These voluntary disclosures aim to help companies to account for nature in their decision making, and in the longer term to drive a shift in global financial flows towards more nature-positive outcomes. How these are adopted at a national level remains to be seen, but in the UK the recommendations of the associated Taskforce for Climate-related Financial Disclosures (TCFD) were enshrined in legislation. If a similar pathway is taken as for the TCFD, then we may see TNFD integrated into mandatory disclosure regimes in future. In any event, it is likely the TNFD’s recommendations will better enable market participants to channel capital towards nature-positive investments.

Another driver in this area is the Science-based Targets Network (SBTN). While many companies may be familiar with the Science-based Targets Initiative or SBTi, which focuses on carbon reduction by requiring organisations to set a net zero target, the SBTN aims to enable targets to be set which account for impacts on both climate and nature. This may become the measure of choice for companies that are keen to show a holistic approach.

Finally, enhanced supply chain due diligence requirements are being introduced both at a UK and an EU level. In the EU, legislation is either in place, for example the Corporate Sustainability Reporting Directive, or set to take effect imminently, such as the Deforestation Regulation. The UK is following closely behind. These requirements, once in place, will require a broad spectrum of companies to consider every step of their value chain and to account for and mitigate the impacts of their activities on sustainability factors.

Osborne Clarke comment

Currently, natural capital is in the shadow of other key board agenda items such as climate change. However the interrelationship between the ecological and climate crises is increasingly recognised, as is the role that nature can play in helping to mitigate some of the worst effects of climate change, for example as part of offsetting markets.

Legislation is starting to be put in place which forces companies to consider and account for the impact of their activities on nature. While some of this will not directly affect investors and lenders, it may lead to additional costs and potentially new due diligence and risk considerations when capital is being deployed. Investors and lenders should therefore keep abreast of these developments and keep processes under review to ensure they are adequate.

While some of the natural capital-related requirements may currently only be voluntary, or not catch financial institutions, there may be merit in being an early adopter. This would ensure the organisation already has the framework in place should the remit of any of the legislation change to capture investors and lenders. Importantly, it would also be evidence of a responsible business approach which is increasingly demanded by key stakeholders and consumers.

Many in the financial sector have been a force for change in terms of climate change mitigation, and there is the scope for the sector to have the same positive impact for natural capital and all that it encompasses.

Some of the content of this Insight was included in the Loan Market Association's article, Flora, fauna and finance: natural capital in the spotlight. If you would like to discuss any of the topics raised, please speak to your usual Osborne Clarke contact, or to one of our experts listed below.